Are Prices Rising or Falling? You Bet!

Today, we give you not one, but two, apparently contradictory, views. One of them is bound to be right. Most likely, both will be.

First, the basics: China is a big country in Asia with a big pile of cash – $1.4 trillion of it. Most of this currency features pictures of dead U.S. presidents. The USA is a big country in North America that emits these dollars, and uses them to buy things it cannot afford and doesn’t really need.

Meanwhile, Americans owe more dollars than ever before. Until 1980, debt as compared to GDP never surpassed 150%. Now it is 330%. Many people are finding it hard to pay their debts. And many leveraged bets made on this debt are now going bad, reducing the availability of cash and credit generally.

So, back to our views:

On the one hand…the world is awash in paper money. So much of it is gushing into the world economy that prices – notably of oil and gold – can only float up higher. And, the dollar, of course, is doomed by inflation. It will be dragged down by the weight of its own numbers.

On the other hand, the world is caught in a credit crunch. The days of reckless lending are over. Assets – real and imagined – are falling in value, prefiguring a major drop in prices across the board. The housing industry got nailed first. Then, property prices headed down. Finance was next. And then technology. And now stocks, generally, are in retreat…with much further to go.

Pick your hand.

The right hand is clearly working the pumps. For clarity, we turn to no less an authority than Mr. Mahnoud Ahmadi-Nejad. You may recognize the name, dear reader. Mr. Ahmadi-Nejad is the desperado in charge of Iran. He was in the news this week, appearing in Monday’s Financial Times. A photo showed him looking rather glum. Of course, you’d probably look gloomy too if Hugo Chavez had his arm around you. Still, Ahmadi-Nejad managed to summarize the entire post-1971 world monetary system so clearly and so precisely; it was almost poetry. A haiku:

"They get our oil

and give us

a worthless piece of paper."

Nobel Prize committee, take note.

Mr. Ahmadi -Nejad is not known as a poet nor as an economist. Still, he went on to give graduate level instruction in central banking: "We all know that the U.S. dollar has no economic value."

How dollars came to have no economic value is a long story. How there came to be so many of them is shorter; the dollar is the USA’s most successful export. Americans are world champion spenders. They may make up only 5% of the world’s people, but they do 20% of its consuming – in dollars. Central banks, fearing that an over-supply of dollars will drive their own currencies up, print local currencies, use the money to buy dollars, and add the dollars to their reserves. This year alone, China has accumulated nearly $400 billion of foreign reserves, mostly dollars. Indeed, it has so many dollars that the Chinese are getting nervous. Wen Jiabao, China’s premier, told an audience in Singapore:

"We have never been experiencing such big pressure. We are worried about how to preserve the value of our reserves."

Meanwhile, another headline from the FT told us that the greenback is under attack in other parts of the world: "Dollar loses grip on Asian debt sector."

"The US dollar has lost is status as the pre-eminent currency for fixed-income products such as corporate bonds in Asia, a sector it used to dominate…" said the story. The dollar itself fell to record lows against practically everything – notably, the pound, the euro, and oil. And if the Fed cuts rates again in December – which is given a 90% probability by the futures market – the dollar will fall further…and prices will continue to go up.

But, while the right hand pumps, the left knocks a hole in the bucket. Week after week, more losses are announced. The latest tally by Goldman Sachs estimates total losses at $400 billion from the subprime debacle, with a total of $2 trillion of cash and credit sucked out of the financial system. Leverage works in both ways, it turns out. When credit is expanding, a deposit of $10 million can be levered into a $100 million gamble. When it is contracting, a $10 million loss reduces the supply of credit by as much as $100 million.

The drop in the dollar and the drop in housing prices have already cost Americans trillions in implied wealth. It’s money that is going, not coming. Says the Economist Intelligence Unit: "The main risk to the world economy is a deflationary spiral in asset prices."

Which hand will do the most damage? We don’t know. Probably both of them will smack us sooner or later.

Bill BonnerThe Daily Reckoning
November 23, 2007

What comes after a trillion?

We ask because today brings word that the world’s derivatives have surpassed $500 trillion. In other words, they’re halfway to somewhere. We suspect they are halfway to Hell…but we don’t know how many zeros there are in the netherworld.

When we left you yesterday…things were getting interesting.

The unstoppable force of inflation was about to smash into the immovable object of deflation.

Today’s news tells us that the two are getting closer and closer. Pretty soon, there’s going to be a collision.

Most newsworthy, Wednesday, the Dow sold off. Dow stocks were down another 211 points, triggering a Dow Theory sell signal. According to Richard Russell, who keeps track of these things, stocks are now in a primary bear market. As near as we can figure, that means that stocks will go down – until they go up. We’ve never gotten the hang of Dow Theory, but some of the smartest guys in the business swear by it.

Of course, it appeared to us a couple of weeks ago that stocks were in a bear market. "The tide has turned," we wrote. With earnings now falling…and liquidity disappearing from the financial markets, generally…we guessed that stocks would have to go down.

What this means, in a broader sense, is that wealth is ebbing away. When the tide goes out, says Buffett, you see who’s been swimming naked – meaning, you find out who’s forgotten to put on his shorts. Prices go down…and he finds he has nothing to protect his most vulnerable parts. But even the investors who were more careful lose money. Everybody loses money. And as Russell puts it, the winner is just the guy who loses least.

When the tide goes out…all the assets that had been buoyed up by flowing liquidity begin to fall down. Of course, we’ve already seen this in the housing market – where, according to the latest reports, sales are off in 46 states…and prices are falling all across the USA, for the first time since the Great Depression. "We still have not hit the worst point in resets, delinquencies and ultimate losses on mortgages," says a report from the OECD. The United States is "on the brink of recession," says the UK Times.

The fall of stock prices so far has wiped out a couple trillion in implied wealth. The fall of the dollar has wiped out a couple trillion more. Goldman Sachs estimates that the credit crunch will take out $2 trillion in credit. And, of course, there are the direct losses from the credit crunch itself…which could add another $300 billion or so. A trillion here…a trillion there…pretty soon, you’re talking real money.

Meanwhile…the unstoppable force of inflation is heading our way. Prices all over the world are heading up…

"Would you believe it…on the rue de Passy they have cakes in the shop windows selling for 30 euros (about $45)?" said a Frenchwoman we met yesterday. "They say inflation is low in France…but I don’t believe it. Many things are as expensive in Paris as they are here in London…"

All over the world people are saying the same thing: official inflation figures lie. And all over the world, they’re probably right. Consumer prices are going up. Yesterday brought reports from Hong Kong and Russia, both of whom announced higher inflation rates. And in the United States, Merrill Lynch reported that the cost of Thanksgiving had risen nearly 8% – or more than twice the official inflation rate – from the year before.

Oil rose to a new record over $97…gold shot up to $798…the dollar fell to a new record low against the euro…and even the rich are having to cut back their spending, says Bloomberg.

While the rich are trimming their sails, the poor are positively sinking. They can’t pay their bills. An article in today’s International Herald Tribune tells us that the number of people who rely on food banks and homeless shelters if rising sharply. New York City food programs are serving up 24% more grub this year than last, says the piece.

And the middle classes are caught between the hurricane of rising living costs…and the doldrums of falling asset prices. They have less money to spend…and more ways to spend it. The unstoppable force is bearing down on them from one side. An immovable object blocks their retreat. They’re going to get clobbered.

They are the ones that own houses and mutual funds…and they are the ones that owe too much money…and whose living expenses have gotten away from them.

They may have substantial salaries…but they have very little margin. Everybody is already working full time…or more. After paying the mortgage, the car loan, the kids’ tuition, their health care premia…and other regular expenses…they have less left over than their parents had. Is that progress or what?

We’ve argued that the "progress" of this generation of Americans is largely an illusion. They earn more. They have more gadgets. Their houses are said to be worth more. But they have actually less real wealth than the generation that preceded them.

Nobody cared when the assembly line workers lost ground. If they were too stupid or too slow to get an office job, said the middle classes, they deserved what they got. But now people in the middle classes are beginning to feel like losers too.

You are either a contrarian, or you are a victim – especially in a credit deflation. When prices fall on most assets…you have to be a contrarian to own the few things that aren’t going down. And when the basic financial formula that has guided a whole generation of Americans breaks down, you have to be a contrarian to find a new one. Since 1980, more or less, Americans have saved less and less of their earnings. Buy a bigger house…buy another car…burn more fossil fuel…spend more money. This spendthrift culture helped to speed up economic growth in Asia. Americans would buy anything, whether they needed it or not. The Asians began to make things, sell them to Americans, and bank the profits. As this process intensified, Asians ended up with more and more money…and more and more of the world’s industry. In other words, America’s middle class spending funded the rise of its most potent competitor. And now the U.S. lumpenhouseholder is in a fix.

The obvious contrarian solution was to NOT do what the U.S. middle classes were doing: Don’t spend; save. Don’t borrow; lend. Don’t consume; make do with what you’ve got. Don’t buy a big house far from your work; rent a little house nearby. Don’t live large; live small. Don’t buy stocks; buy gold.

During the past 27 years, doing these contrarian things was as unappealing to most people as a cheap hair transplant. They felt a little ridiculous driving around in an old car…or having a kitchen with linoleum on the countertops.

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About Bill Bonner:

Since founding Agora Inc. in 1979, Bill Bonner has found success in numerous industries. His unique writing style, philanthropic undertakings and preservationist activities have been recognized by some of America’s most respected authorities. With his friend and colleague Addison Wiggin, he co-founded The Daily Reckoning in 1999, and together they co-wrote the New York Times best-selling books Financial Reckoning Day and Empire of Debt. His other works include Mobs, Messiahs and Markets (with Lila Rajiva), Dice Have No Memory, and most recently, Hormegeddon: How Too Much of a Good Thing Leads to Disaster. His most recent project is The Bill Bonner Letter.